Upstart: A Coiled Spring Waiting For Lower Interest Rates (NASDAQ:UPST)

Upstart (NASDAQ:UPST) has seen great volatility as of late, likely due to lower confidence in interest rate cuts. The company continues to struggle amidst the current interest rate environment, though the company already appears poised to begin benefitting from easier comparables. Management has responded to the tough macro environment by cutting costs, and I expect those efforts to pay dividends if and when the macro environment improves. The stock looks attractively priced at current levels, warranting a ratings upgrade. I rate the stock a buy for investors OK with above-average volatility.

UPST Stock Price

I last covered UPST in December, where I explained why I was selling my position and withdrawing my buy rating for the stock. That report proved to have fortuitous timing, as the stock has since declined by 50% during a period in which the broader market returned 5%.

The relative underperformance has improved the value proposition, though valuation isn’t really the problem here.

UPST Stock Key Metrics

UPST was a highly favored tech stock during the pandemic, which investors believed (including yours truly) was tackling a huge market opportunity by increasing credit availability. Specifically, UPST aims to utilize its artificial intelligence-driven model to approve loans, which might lead to higher approval rates and lower APRs than the typical FICO model.

The idea was that UPST could have an asset-light model due to being able to earn fees from selling their originated loans to institutional investors. Unfortunately for UPST, post-pandemic headwinds as well as the rapidly rising interest rate environment threw a wrench in their operating model, with institutional capital losing faith in the projected returns, which heavily constrained the company’s ability to grow. That said, the company is making progress on bringing back expected ROIs back to their target range.

In its most recent quarter, UPST saw revenues decline 4% YoY to $140.3 million, coming ahead of guidance for $135 million. UPST lost $9.7 million in adjusted net income, beating guidance for a $14 million loss. As has been usual lately, the company generated strong 63% contribution margins – pricing power has been the silver lining amidst a plunge in origination volumes.

The company saw personal unsecured loan origination decline by 15% YoY. This represented some stabilization from the 39% decline posted in the third quarter. I credit the stabilization as being due to the company now benefiting from easier comparables, and expect this trend to continue over the coming year.

UPST ended the quarter with $467.8 million in cash versus $1.1 billion in debt. The company also held $1.17 billion in loans on the balance sheet.

Management considers $411 million of those loans to be held for “R&D purposes,” but investors may be concerned about the 19% QoQ jump in loans held on the balance sheet. UPST has been advertised as being an asset light operator in the loan origination space, but it appears that the company has needed to temporarily digress from that model amidst the volatile interest rate environment.

UPST had previously disclosed that it had signed committed capital agreements, but for now, these agreements still look quite modest.

Looking ahead, management has guided for 21% YoY revenue growth to $125 million and 13.6% YoY revenue from fees growth to $133 million. This would be the company’s first quarter featuring YoY revenue growth since the second quarter of 2022.

On the conference call, management again blamed their poor top-line growth as being due to the tough macro environment, as they are constrained by their 36% upper limit. Not only does the company have to automatically decline many potential borrowers due to the limit, it is possible (if not likely) that many potential borrowers may also be discouraged by the higher proposed interest rates.

That may make some investors wonder if UPST is reliant on a cut in interest rates. Management appears highly attuned to this possibility, and has been undergoing aggressive cost-cutting in order to, in their own words, ensure that they “can thrive through a wide range of economic conditions.” While the company is not yet profitable today, it is encouraging to see the company continue to reduce operating losses even in the current environment. Management touted their 89% fully automated approval rate, as well as the fact that they finished 2023 with “26% fewer head count than at the end of 2022.” The appeal of a fully automated loan approval process is compelling, as one would be able to avoid the usual processes like “having to upload documents, schedule phone calls, or wait hours or days for a response from a credit analyst.” I am reminded of my original attraction to the stock, but the higher interest rate environment has clearly stalled the growth story.

Management noted a desire to get to EBITDA breakeven this year, but used both “hope” and “priority” in describing this commitment. That said, I would not be surprised to see management deliver on this front given that the company looks poised to benefit from easier comparables on the revenue front, while benefiting from ongoing cost discipline.

Is UPST Stock A Buy, Sell, or Hold?

UPST is not yet out of the woods, as interest rates have not yet declined, and the company has not yet figured out how to be profitable in the current environment. With inflation still staying stubborn, investors are grappling with the possibility of a delay to planned interest rate cuts. Yet, as I mentioned earlier, UPST already stands to see stronger revenue growth rates this year, if only due to the poor financial results of the recent past now representing easier comparables. Consensus estimates have the company seeing 13% YoY growth this year, followed by a surge to 30% growth in 2025. I note that consensus estimates of $756 million in 2025 revenues is still markedly lower than the $907 million mark earned in 2022.

The stock might not appear to offer so much value, given that the company is still not yet profitable. But if the company can continue to make progress towards cost-cutting, and we benefit from some reduction in interest rates, then I can see a real case to buy the stock here. I can see the company generating a 25% net margin over the long term – I note that the company generated an 18% operating margin in 2021. That would place the stock at just 13x long-term earnings power, and we might be applying trough revenues in that calculation. I could see the stock re-rating to the 20x earnings or even higher range if it can return to being a secular grower – the pandemic era secular thesis centered around UPST earning a fee on more and more loans as more and more financial institutions sought to invest in its products. Due to its reliance on interest rates, UPST is the kind of stock that might be considered a strong growth stock in a low interest rates environment and forgotten about when interest rates are higher. This dynamic elevates the risk profile of the stock, which offsets the low valuation.

What are the key risks? I have already mentioned interest rates as being a crucial risk for the company. UPST may generate solid YoY revenue growth this year due to lapping easier comparables, but I suspect that consensus estimates for 2025 and beyond are factoring in cuts in interest rates. It is hard to understand how UPST can generate sustainable revenue growth in this environment due to being constrained on capital (something that may not ease unless interest rates fall). UPST is not yet profitable, and thus there is no implicit support for the valuation in this environment. There were many quarters over the past few years in which management appeared committed to an asset light model, but that commitment appears to have disappeared given the macro headwinds. It is possible that management adds more loans to the balance sheet, which due to the implied reduction in the cash balance might increase the risk profile of the stock.

Conclusion

There are no visible catalysts in sight for UPST besides a reduction in interest rates, which may ease capital constraints and reignite the growth engine. The stock looks cheap under such scenarios, but the company remains unprofitable in the current environment. I am of the view that the company can continue making progress on the profitability front, which may set it up to deliver strong results if or when macro conditions improve. It is hard to get conviction behind the name due to the reliance on lower interest rates, but I am upgrading the stock to a buy rating due to the low valuation.